Why the crisis in Cyprus matters

Sunday

Mar 31, 2013 at 6:00 AM

By Peter S. Cohan WALL & MAIN

Odds are good that you have no connection whatsoever to Cyprus' banking crisis. But with the world being flat, its woes offer another nail in the coffin of an idea that is widely accepted among economists, namely, that capital should flow freely around the world.

Before getting into why this idea is very costly to people around the world, let's look at what happened in Cyprus. For reasons that are still being investigated, Cyprus' banking system froze deposits on March 16. And prior to the crisis, that system held 64 billion euros on deposit, at least 10 percent of which was anticipated to be withdrawn when its banks reopened on March 28.

The European Central Bank, which is planning a 10 billion euro bailout of debt-heavy Cyprus, wanted to ensure that there was enough cash in the country once people started making withdrawals. So, the New York Times reported, that by the afternoon of March 27 an airplane loaded up with 1.5 billion euros in a container was parked at Cyprus' Larnaca airport. And police reportedly escorted the container to Cyprus' central bank with the intention of safeguarding the cash.

Not surprisingly, the economic consequences of this are considerable. Cyprus' second-largest bank, Laiki Bank, is being liquidated, taking the jobs of thousands of employees down the tubes. Since March 16, businesses have stopped paying their employees, and importers have not paid for the goods they were bringing onto the island, meaning that shelves are growing barren.

Not surprisingly, Cyprus is going to violate a principal of economics that has been considered unquestionable for decades: It is going to limit the flow of capital out of its banking system and the country. Cyprus will prohibit electronic transfers of funds out of Cyprus to other countries, and individuals will only be able to take 3,000 euros out of Cyprus — 7,000 euros below the pre-crisis ceiling.

Moreover, daily ATM withdrawals will be limited to 300 euros per day, and credit and debit card charges will be limited to 5,000 euros per person, per month. Banks won't even cash checks, but they will accept deposits.

Cyprus will shift the burden of the losses onto big depositors, whom it expects to lose 40 percent of their 14 billion euros in long-term deposits. But along with that haircut, those depositors will get shares in a newly capitalized bank.

Those big depositors are suffering the downside of the free flow of capital. For the most part, they are very wealthy Russians who have managed to gain control of Russia's big natural resources companies. By depositing their wealth in Cyprus' banks, they paid lower taxes and could keep it parked in a place that would be difficult for Russia to expropriate should those wealthy oligarchs fall out of favor with Vladimir Putin.

Cyprus' citizens will also suffer, as its economy shrinks at a rate that economists estimate will range between 5 percent and 10 percent in 2013.

Why should you care about this economic disaster? Simply put, it would have happened here in 2008, was it not for a massive government bailout. And there is little to stop it from happening again.

In principle, it also happened in Iceland, in a more damaging way, a few years ago.

As professor Srini Rangan and I wrote in our 2010 book, "Capital Rising," Iceland's economy and banking system collapsed thanks to the easy flow of capital across national borders.

Iceland offered a very high 8 percent rate on its bank deposits, which lured money from around the world, particularly Britain. Iceland went from being a country that depended on fishing and tourism to one that was dominated by its investment bankers. They took those deposits and "invested" them.

Unfortunately, when the financial crisis hit in 2008, depositors around the world scrambled to get their cash out of Iceland's banks. Unfortunately for Iceland, that money flowed out of the country just as quickly as it had flowed in.

What happened in Cyprus is a similar story with a unique twist. Not only is it yet another cautionary tale of the dangers of loose capital controls, but it also threatens to put a serious crack in the eurozone. After all, Cyprus now hosts two classes of euros: liquid, and frozen.

And trying to figure out what those frozen euros are worth is the kind of problem that could erode the trust on which the global banking system is supposed to be founded. It makes me wonder — yet again — why we even allow bankers to bet deposits that so many of us expect to be safe.

Peter Cohan of Marlboro heads a management consulting and venture capital firm, and teaches business strategy at Babson College. His email address is peter@petercohan.com.